Anyone in the e-payment space will not have failed to notice the attention that Bitcoin has been attracting over the last few weeks. I have to say that I was surprised by the interest from journalists — I was even interviewed for the Wired podcast and for New Scientist — for what is, after all, pretty small potatoes. Thanks to its open and transparent nature, it’s easy to see just how big the Bitcoin economy is. This is how it looked on one of the biggest exchanges on 18th May 2011 when I was talking to a European journalist:

So that’s a quarter of a million dollars in trades, although you can’t tell how much of that is people shifting bitcoins between their own accounts and how much is new money coming in. That’s not a huge business. Yet in some of the more hysterical reporting — the most dangerous idea ever, etc etc — you’d think that China was switching its reserves from dollars to bitcoins.

Because on Friday, the Bitcoin experienced a rather dramatic drop. In the words of one anonymous commenter: “it looks like it lost 1/3 of its value in the last 24 hours. Lots of big sells, complaints of liquidity, and pissed off nerds.”

As I somewhat uncharitably posted on Twitter, “help I want my anonymous, untraceable digital cash back!”. Now we read that Bitcoin is dead, it’s a scam, it’s a bubble etc etc. So what’s the truth? What strategy, if any, should stakeholders in the e-payments space consider?

The only thing that’s even kept Bitcoin alive this long is its novelty. Either it will remain a novelty forever or it will transition from novelty status to dead faster than you can blink.

I think it’s more than a novelty. I’d actually started writing something about Bitcoin a while back, when twitter friends pointed me to a paper “Mobile Payment Systems and Services: An Introduction” by Mahil Carr which says that (with no evidence at all to support the assertion) “mobile payments have to be as anonymous as cash transactions” and I’d been involved in a subsequent discussion about whether bitcoin might be suited to this environment. I couldn’t help but observe that cash is the wrong benchmark: it isn’t as anonymous as some people think.

On April 26, a state police trooper was called to the Subway after the owner said one of her employees found three “obviously counterfeit” $20s in the safe. The owner checked the surveillance video and saw one of her employees, the 17-year-old boy, take bills from his pocket and exchange it for money in the cash register… Before exchanging the bills, the employee marked the bills with a counterfeit marking pen, which resulted in a dark brown mark, meaning they were fake.

In a world of mobile phones, twitter and CCTV, anonymity is a high bar to set. In the virtual world, however, anonymity can be an implementation choice, should it be a requirement for a payment system. Personally, I don’t think it is. Transactions need to be private, not anonymous, and that means a different set of design principles. In all of my experience, even during my days as an firm proponent of anonymity as a key element of retail transaction schemes, I never saw the slightest demand for this from any of the stakeholders, including consumers. Nevertheless, that doesn’t mean that new technology could not, quite easily, lead to entirely new ways of making payments recognising the fact that the underlying technology has changed beyond all recognition in the previous generation.

Visa processed 37 billion transactions in FY2008, or an average of 100 million transactions per day. That many transactions would take 100GB of bandwidth, or the size of 12 DVD or 2 HD quality movies, or about $18 worth of bandwidth at current prices.

Will Bitcoin be the new technology to revolutionise money? To answer that, I have to step back a little. Generally speaking, I think there is a problem with language, because people (I mean normal people, not people like us) never think about what money is or how it works. Sterling (the currency) could continue to exist even if there were no notes printed by the Bank of England or coins produced by the Royal Mint. People could sign contracts for Sterling payments, but those payments would be commuted for execution: when the payment falls due, the counterparties agree on a mechanism for exchange (which might be Dollars in a bank account, Euro bank notes or cowrie shells). Why would they, then, sign a contract in Sterling in the first place? Well, it’s because they expect the currency to serve as a means for deferred payment in that its value in the future is predictable. I’m not saying that this always works well, because currencies are not as stable as might be hoped, but that’s the theory.

Now let’s move on to this specifc implementation. Bitcoin is a decentralised, peer-to-peer means of exchange. If you have a bitcoin, which is just a string of numbers, you can send that bitcoin (or a subdivision of it) to anyone else on the interweb. If you want to understand how Bitcoin works, a good place to start is the original paper on the topic, “Bitcoin: A Peer-to-Peer Electronic Cash System” by Satoshi Nakamoto. I’m no expert on cryptography but there’s no reason I know of to question the basic idea: use a computationally difficult challenge to create strings of bits that it’s hard to make but easy to copy, then use digital signatures for transactions. I get my bitcoin (a string of bits) and then in order to transfer them to you I add a digital signature and send them to you. Every time we do a transactions, we tell (essentially) everybody else that the bits now belong to you. The closest analogy to this is the stone currency of the island of Yap, in the South Pacific. The huge stones that represented money never went anywhere, people just remembered who they belonged to.

Every transfer of ownership is public knowledge, and the physical stone can stay in place.

Rather like Bitcoin, in some ways. So far so good. But why would people use Bitcoin? There seem to be three key reasons: one is that they want a cheap, irreversible online means of exchange (cash for the 21st century), another is that they want an anonymous means of exchange (coins for the 21st century) and yet another is that they want to use of non-government currency because they don’t trust governments to manage money properly. Let’s have a quick look at each of these.

Frictionless low-value payments

Now, having been involved in a previous attempt to create a global, decentralised, peer-to-peer means of exchange that addressed the first two of these issues, Mondex, I’m naturally interested to see how Bitcoin develops. I’m frankly sympathetic to many of its goals, because I too believe that a “frictionless” means of exchange for the online world would stimulate a new era of trade, and therefore prosperity. In an essentially frictionless system, where the transfer of value is simply the transfer of bits, the key problem to overcome is that of “double spending”. In other words, if I send you some value (bits), how do you know that I haven’t already sent that value (ie, a copy of those bits) to someone else? There are a number of different approaches.

The usual solution is to have a central register.

The Mondex solution was to use tamper-resistant hardware (smartcard chips) to store the balances.

The Bitcoin solution is to distribute the transaction record across the network (every node knows every transaction), which works provided that the timestamps can be co-ordinated properly (otherwise the nodes wouldn’t know the order of the transactions). When you get a bitcoin, it takes a few minutes before you can spend it again because the network needs to be updated.

Which is best? It’s not really the topic of this post, but I’d say a combination of 1 and 2: a central register plus tamper-resistant hardware so that low-value payments can handled quickly, offline in some environments.

Anonymity

What the general public want is privacy, not anonymity. If I lose my wallet, I want my money back. This is why I always carry prepaid cards when I travel, rather than carrying cash. In fact I’ve just been through the very process of getting my money back because I gave my son a prepaid Euro card to use on a school trip in Spain (a Thomson MasterCard) and he lost it when there were still €70 on the card. No-one else can use that card (they don’t know the PIN and it has no name on it so they can’t pass AVS online) and I am getting the money back. Personally, I think this is closer to the kind of cash that makes sense in the new economy. It’s economically infeasible (although not computationally infeasible) to track and research every payment, but when something goes wrong it can be restored. And if I did use the card for some illegal purpose, the police could get a warrant and Thomson would of course point them to me.

I’m not sure that I want to live in a society where unconditional anonymity exists for payments. I don’t want the bad guys to be able to operate with impunity. But neither do I want every little transaction I make trawled by corporates, the media, the government. The solution has to be payment systems with privacy built-in, so that privacy is the default and it takes legal process to uncover transaction details.

Private Currency

This may well be the most contentious area for debate. I am a Hayekian, in that I would prefer to see a system of competing private currencies rather than government monopolies, because I think that sound money is an important base for the economy. But this issue is, to my mind, orthogonal to the other two. You could implement competing private currencies in anonymous, pseudonymous or absonymous (note to pedants: this is a word I made up, that’s why it fails the spell-check, not because I spelt it wrong) ways and you could implement the mechanism for exchange using all sorts of systems. Whether transactions are reversible or not has nothing to do with the currency.

Trajectory

Is Bitcoin a good currency? I suspect not, but I’m not an economist, so I must defer to the experts. The question that most of our clients are interested in is whether Bitcoin will form a niche parallel economy or whether they will scale into the mainstream economy. I have a suspicion that this won’t happen, and that’s because the anonymity that is the attractive feature to the early-adopting bitcoiners is not attractive to the mass market.

The best strategy is to learn, and to think about ways that the cryptography at the heart of Bitcoin can be used to deliver new kinds of services in a connected environment. I don’t think cash will be one of them.

These opinions are my own (I think) and presented solely in my capacity as an interested member of the general public [posted with ecto]

Anonymity is talked of a lot with respect to Bitcoin, but as far as I can tell it is a lot less anonymous than cash and not much more anonymous than standard payment cards.
Bitcoin transaction history and balance is public information, so it is quite easy to trace currency from one person to another. Now there aren’t names associated with the accounts, so with care someone can create a pseudonym and spend Bitcoin, but the source of that money will be known. If people use Bitcoin in the course of committing a crime that gets sufficient attention from law enforcement, the flows of money will get tracked down fairly quickly.
There is some discussion about a mix for Bitcoin, where you send in dirty Bitcoin and get out clean Bitcoin. This is more commonly known as money laundering and will be dealt with in the same way as those for cash. If Bitcoin gets big I expect there will also be pressure for KYC rules to be applied, and Bitcoin doesn’t have the anonymity needed to resist this.
I think the best analogy for Bitcoin would be a pre-paid debit card, with non-existent KYC requirements, but where getting full global transaction history doesn’t require serving requests on multiple issuers but where it is public information.
There are proposals of truly anonymous digital currency, and have been for a while, but none of them have got off the ground. Maybe someone will try combining some of the innovations that Bitcoin developed (particularly around de-centralization), with truly anonymous digital cash, to build its successor.

Steven, the gentleman that recently had $500k worth of bitcoin hacked and stolen will be glad to hear from you that “it is quite easy to trace” and that “the source of that money will be known”. Also, your encouraging statement that “the flows of money will get tracked down fairly quickly” should provide him some additional comfort as he comes to terms with this theft.

Using the quantity of BTCs to cross the wire isn’t a very good metric for calculating turnover. Right now we are seeing record levels of transactions but even much higher record levels of bitcoins transferred.
Though most of these transfers could be the response to the tone bitcoiner losing 25K to theft. Simply moving bitcoins from one wallet to a more secure wallet, even on the same computer, will appear no different from a payment sent halfway around the world.
One method to measure transaction volume is the Bitcoin Days Destroyed metric.
– http://en.bitcoin.it/wiki/Bitcoin_Days_Destroyed
There is no publicly available data feed or chart yet but the source to compute it is open source.

Elpresidenten01, there is no absolute method to determine transaction types/purposes, but the commercial transactions portion can be best approximated by the ‘Bitcoin Days Destroyed’ metric pointed out by bitcoinmoney, which will tend to strip out the short-term transactions to oneself.
Also, keep in mind that as more eWallet service providers (MyBitcoin.com) and exchangers that maintain accounts (MtGox.com) come online, those intra-account transfers will be excluded from any metric because they occur outside of the bitcoin block chain.

The guy who lost $500K didn’t really as he bought last year when the exchange rate was very low. If he actually tried to sell now the volatility in this commodity would crash the price back down. He was also very stupid as it is much easier to protect bitcoins than cash – that said a lot of people don’t understand bitcoin at all.
Mybitcoin.com is offering to store your bitcoins in a safe place. Encrypted and backed up they are safe on your computer. Giving anonymous tokens to someone you don’t know and who is not regulated (mybitcoin.com) is as foolish as giving your life savings to someone who emails you with a fantastic investment opportunity in selling ice to Eskimos.
I’m surprised you are so dismissive. This is far more significant a development than the Stroud pound or other alternative currencies. Who knows what will happen with bitcoin, but it is the most innovative thing I have seen in the payments space for a very long time. It is also the most ethically challenging. Some of the comments about KYC being needed if Bitcoin gets big is akin to the music industry trying to regulate BitTorrent. The network, by design, cannot work like that.

“I’m surprised you are so dismissive”
I don’t think I was dismissive: I think I explained in reasonable detail why I think Bitcoin is unlikely to succeed even though I strongly support one of its goals and think that the technology is worth studying.

You said:
Which is best? It’s not really the topic of this post, but I’d say a combination of 1 and 2: a central register plus tamper-resistant hardware so that low-value payments can handled quickly, offline in some environments.
But I fail to see why! Could you elaborate?

Thought Leaders

We help our clients bridge the gap between business and technology by providing practical, impartial advice at all stages in a project life cycle from the conceptual phase through to completion. We help organisations evaluate, prototype and design new business concepts, develop new products and services and test and certify complex systems using advanced techniques and fully-automated robotic test management.